3 Questions About Obama's Tax Credit for Innovation

By Derek Thompson

As part of a new stimulus package to encourage businesses to hire and invest, the president proposed to make permanent the research and experimentation tax credit.

How does that tax credit work? Very simply, the credit is calculated by counting research and experimentation costs, multiplying by a certain rate, and subtracting (or deducting) that amount from taxable corporate income. The more you research and experiment, the more you save on your taxes. (More here.)

Here are some questions about the tax credit that I've received in comments and emails:

1) Everybody likes innovation, but why do we need a tax credit? Aren't the values of research self-evident? Many of the do. But some of the benefits of research escape
companies that put in the cost. "Economists favor the credit because
there's a lot of evidence that
companies don't capture all of the benefits from their research," Rob
Atkinson, president of the Information Technology and Innovation
Foundation, told Ezra Klein. "Those
benefits spill over to other companies and industries."

2) Second, is the credit working? Is it actually creating more R(esearch) and E(xpermentation)? This is hard to measure, but Martin Baily of the Brookings Institution, who has researched the tax credit since the 1980s, told me he thinks it is an effective stimulus of research. His former colleague Bronwyn Hall has concluded that while the government might lose more tax revenue than it induces in new research, the full benefits of the tax credit are positive.

3) Third, is there a better way to encourage research and experimentation -- basically: innovation? There may be. Martin Baily has been a big advocate for the tax credit. But today, he told me, "I've gotten older and wiser, and if you offered me a package that stripped out the business tax credits in exchange for lowering the overall corporate income tax rate, I'd take that package."

What's he talking about? The corporate tax system is a bit like the income tax system you're familiar with. You can pay taxes on income at one rate, but you can shrink your tax bill with all sorts of deductions and credits for donating to charity or saving money or going to school.

Similarly, companies are taxed at one, high rate -- 35 percent -- but the government also pays them back back to do things we think are good. Financing a new investment with debt, are you? Here's a tax break. Researching and experimenting, are you? Here's a tax break. As a result, some economists argue, we're scaring multinational companies away with a high tax rate, but paying companies to do things they might do anyway out of an even smaller pool of money. The solution? Strip out the fat. Or in economists' parlance: broaden the taxable income and lower the rate.

"It is hurting the United States and multinationals that we have a higher tax rate," Baily said. "So I think if you were to offer me a package that gets rid of all these tax breaks, and the intended result was to collect more revenue with a lower overall tax rate, I'd be willing to take that package.

"If we're not going to make fundamental changes to the tax code, I like the permanent R&E credit. But if you had the power to sweep away all this stuff, I'd take the bargain."